The Fed holds the interest rate steady

The Fed decided today to keep the federal funds rate at 5.25%. This was clearly not an easy decision to make. On the one hand, you have the fact that the inflation rate - measured by the core personal consumption expenditures deflator, which the Fed seems to pay especially close attention to - has been above 2% (the upper limit of the Fed's presumed target range) for about two years now, and over the last few months has been rising sharply:













On the other hand, we have this analysis from James Hamilton (via Brad DeLong):

The Census Bureau yesterday released August data for housing permits and new housing starts, both of which confirm that we are in the midst of a significant housing downturn... The 2006 decline is already substantially worse than what we saw in either the 2001 recession or the 1994 "soft landing."... It is hard to find an example of a decline of this magnitude that wasn't associated with a recession.... My main question is how long it will take the same people who were sniping at Bernanke for not tightening enough now to start hollering that he went too far.

The Fed is counting on the slowdown in the housing market to cool off the economy just enough to bring inflation back under 2% without triggering a recession. This is the "soft landing" scenario. I would like to believe the Fed is right. However, I recall the situation in Fall 2000 when the Fed made a similar calculation about the decline in the stock market. Back in October 2000, after a couple of years of interest rate hikes that left the federal funds rate at 6.5%, the FOMC surveyed the economy and concluded thusly:

All the members agreed that their views regarding the outlook for inflation were consistent with retaining the press release sentence indicating that the risks remained weighted toward higher inflation over time. Some expressed the opinion that those risks were now less decidedly tilted to the upside and that a reconsideration of the sentence might be warranted over the next several months, but they believed that a change at this point would be premature. While the prospects of a significant rise in inflation seemed quite limited for the nearer term, the members agreed on the need to remain especially vigilant for signs of potentially rising inflation over the intermediate term, particularly since any increase in inflation would occur from a level that in the view of many members was already on the high side of an acceptable range.

That is, just as in today's statement, the Fed was more concerned with the risk of rising inflation than the risk of recession. By November there were clear signs of a slowdown, but the Fed continued to weigh the risks of rising inflation more heavily:

Still, growth had slowed more quickly than many members had anticipated, and financial market and other developments now seemed more likely to keep pressures on resources from mounting over coming quarters. Under the circumstances, the members focused at this meeting on the potential desirability of moving from a statement of risks weighted toward rising inflation to one that indicated a balanced view of the risks to the Committee's goals of price stability and sustainable economic growth. The members agreed that a stronger case could be made for a shift to a balanced risk statement than at the previous meeting. A few indicated that the decision was a close call for them, and several commented that developments might be moving in a direction that would make a shift advisable in the relatively near future. Even so, they were unanimous in concluding that such a change would be premature at this time. Concerns about the possibility of rising inflation persisted. And while the members could see an increased risk of a marked slowing of growth relative to the rapid rate of expansion of the economy's potential, the degree to which growth in demand might remain sufficiently damped to contain and offset those inflation pressures was quite uncertain. Moreover, a shift in the Committee's published views might induce an undesirable softening in overall financial market conditions, which in itself would tend to add to inflation pressures. The members concluded that retaining a risk statement weighted toward more inflation pressures would best represent their current thinking, but they believed it was desirable to provide some recognition of the emergence of increased downside risks to the economic expansion in the statement to be released after this meeting.

In the December meeting the Fed again resisted a cut in rates, but changed its "bias" statement from one emphasizing the risk of higher inflation to one noting a balance of risk between inflation and recession:

With regard to the consensus in favor of moving from an assessment of risks weighted toward rising inflation to one that was weighted toward economic weakness, with no intermediate issuance of a balanced risks assessment, some members observed that such a change was likely to be viewed as a relatively rapid shift by some observers. The revised statement of risks, even though it would not be associated with an easing move, could strengthen expectations regarding future monetary policy easing to an extent that was difficult to predict and could generate sizable reactions in financial markets. At the same time, it might raise questions about why the Committee did not alter the stance of policy. Nonetheless, the Committee's reasons for not easing today were deemed persuasive by most members, while shifting its statement about economic risks seemed clearly justified by recent developments. In one view, even though the risks of a weakening economy had increased, a statement of balanced risks would be preferable because further moderation in the expansion might well fail to materialize.

Two weeks later, the slowdown had become so obvious that the Fed met in an emergency meeting to lower the federal funds rate by 50 basis points. The NBER has since determined that a recession began formally in March 2001. The Fed's job is to lower interest rates about six months before a recession hits, so the monetary policy action has time to affect the economy before all hell breaks loose. The Fed failed to do its job last time around.

Incidentally, in November 2000 the Gettysburg College Fed Challenge team looked at the inverted yield curve and recommended an immediate cut in interest rates. The students were informed by the Fed economists that this would be premature.